Currency Demonetization in India – The Past, Present & Future

India has banned Rs. 500 and Rs. 1000 notes, and is coming up with new notes to replace the old one.

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In this podcast, we discuss

1. Did you know that India once banned a note equivalent to Rs.6.5 lakh today?
2. How did the markets react to this sudden news?
3. Which sectors could benefit, and which would suffer due to this?
4. Lastly, what happened in China when there was a similar cash crunch a few years ago?

Investment professionals discuss this event in the podcast ‘Market Diaries’.

Read the Transcript of this Podcast:

Aniruddha: Welcome to Market diaries, a podcast where we discuss events in the world of finance. This podcast is presented by Multi-Act, a rare, unbiased International Equity Research and Investment House.

Presently we are in the 44th week of this year, which has ended on the 11th of November 2016.

After one week of Diwali, PM Modi burst the loudest firecracker ever heard on the streets. On 9th November 2016, the PM announced the scrapping of Rs. 500 and Rs. 1000 notes, and the entry of new 500 and 2000 rupee notes.

There are already many articles floating on websites, and discussions happening on TV, to guide people about how to convert their old currency to new one, and how to tackle the days till we get our hands on the new notes.

In this podcast, we will look at this issue from an analytical angle. Before we begin, let us understand the uniqueness of this situation. Jyoti, can you tell us the history of such drastic action by a government.

Jyoti: The demonetization of 500 and 1000rupee banknotes is a step taken by the Government of India in November 2016 to fight corruption and black money issues in the country. But the idea is certainly not unique or new. It’s not the first time the government has demonetized banknotes.

It has been done twice so far in India’s history. This time, the attempt is to crack down on black money.

In January 1946, Rs1, 000 and Rs10,000 banknotes were withdrawn. In 1954, Rs1,000, Rs5,000 and Rs10,000 new notes were reintroduced and were again demonetized in January 1978 as a means to curb forgery and black money.

Aniruddha: Wow. I am curious, how much would the 10,000rs note in 1978 be worth in today’s amount?

Jyoti: Let’s look at in terms of gold. That note would have bought you 220 grams of gold in 1978. So in today’s terms, that was a 6 and a half lakh rupees notes.

Aniruddha: 6 and a half lakh rupee note! Wow. So tell us, what was the reason for scrapping of notes this time?

Jyoti: RBI explained that the supply of notes of all denomination was increased by 40% in last 5 years. The 500 and 1000 rupee notes increased by 76% and 109% respectively in this period owing to counterfeit money. This was then used to fund terrorist activities against India. As a result, the step of eliminating the notes was taken.

Aniruddha: What was the markets’ reaction to this news?

Jyoti: There were sharp movements in the broad market indices, but it is difficult to separate the effect of this decision and the selection of US president.

The real impact of the demonetization process is seen in small and mid-sized stocks and some sectoral indices. BSE Realty index was down by 10%. Diamond, Gems and Jewelry sector was down by almost 6%. Particularly, titan was down by 6% and PC jeweler was down by 9%.

In some rich parts of India, sale of gold increased on 9 November with an increased 20 to 30% premium as people bought gold in exchange of their unaccounted cash.

Aniruddha: Thanks Jyoti. Nimisha, what do you think about this move?

Nimisha: In the long term this move is definitely beneficial for the nation. The ban on high value currency notes is one of the tools in India’s fight against corruption and black money and a step towards cashless economy. If corruption and black money is curtailed, Government revenues will increase and many transactions which were not accounted earlier will now be recorded in country’s GDP. So it will give boost to the reported GDP numbers.

Aniruddha: So it is beneficial in the long term. What about in the short term? We are seeing some choppy movements in the market.

Nimisha: Well, in short term this move definitely has negative implications for some stakeholders.

For instance, after this ban, there will be shortage of currency in the economy for few days or even a few weeks. Because of limited currency available with people, there will be slowdown in spending. Till the time there are limits on cash withdrawals, people will prefer saving the currency they have by cutting discretionary cash spending. The impact would be higher in rural areas where most transactions are still on cash basis. But this will be a hassle only for a short period.

Then there are explicit and implicit costs of abolishing the currency in circulation and printing new currencies. The direct cost being cost of printing, replacing and storing the notes. Then opportunity cost of lost business for banks in this transition period. And the largest of all is that, the huge pile of unaccounted cash hoarded by many will now become worthless. Earlier, that unaccounted money was spent in the economy in cash, now that money might be completely lost.

Here, I think that we should look at these costs as investments in India’s long term economic development. If because of these losses, corruption and black money is curtailed to some extent then the benefits will be far reaching than these costs.

Aniruddha: Hmm. Let’s talk about investment. Which sectors do you think will be affected?

Nimisha: Here are the sectors that can benefit from this decision. This move is a step towards a cashless economy. So banking sector can benefit due to increase in bank transactions and increase in bank deposits. Housing finance sector can benefit by reduction in ‘black’ portion of the real estate prices, because people may have to take more loan.

Mobile wallets and other electronic payment facilitators will also benefit from increase in transactions. As per a news article, “Freecharge” a mobile wallet saw a sharp 12x jump in the average wallet balance in one night. Other wallets like PayTM also saw similar trend.

Now, the sectors which could get adversely affected are the ones where undisclosed income is utilized the most. Luxury cash spending in retail, entertainment, tourism, electronics etc. may see decline in demand.

Real estate and gold jewelry are the sectors which have material cash transactions and are often used to hoard undisclosed money. But in real estate and jewelry sector, flow of black money is more towards unorganized players. So the curb on cash transactions will create a level playing field for organized players.

In India, gold has been a popular mode of saving for many households. Because of this demonetization, people’s faith in the paper currency may reduce and result in higher demand for gold.

Aniruddha: Thanks Nimisha. Abhijit, while such crackdown on money generated from corruption and illegal activity is a populist move, surely there will be some short term bumps as well?

Abhijit: Yes, agree in the long run an attempt to convert as much economy as possible into a legitimate and accountable stream is positive. But the short term pain might be there.

Aniruddha: What kind of short term pain are we talking about?

Abhijit: Yes, you can see recent example like China where general discretionary consumer items faced slow down after corruption cracked down. Though there was no currency attack, premium liquor and casino like discretionary item spending collapsed in short period. So similarly, when you try and clean up the nooks and corners, there can be short term dampening impact on selected sectors. But actually in the long run there can be even better accounted economy. So this incident again shows, how fiat currency is one of the form of power in the hands of Governments.

Indeed, this incident truly highlights the government’s control of the fiat currency.

Aniruddha: So let me summarize the discussions and opinions so far. Scrapping of notes has been attempted in past in India. But that didn’t make people any more prepared for such sudden action. There remains an atmosphere of confusion and worry, and it is reflected in the market returns as well. While some sectors will benefit and some will be affected adversely, we believe that this move is good for the long term. This may not turn us completely cash less, but at less it would make people use less cash. The sharp spike in gold highlights the fact that gold remains the people’s currency, and whenever there is mistrust in government’s currency, people turn to gold.

That’s all for today, folks! Thanks for tuning in. It was great having you in today’s discussion. Do visit us at www.multi-act.com. See you next time in the next podcast of Market diaries. Happy Investing! Aniruddha signing off.

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